THE MOST POWERFUL financial ideas are those that help us make better money decisions—by providing a lens through which to understand ourselves and the world around us. Examples? Think about notions like loss aversion, diversification and market efficiency, all ideas frequently mentioned in HumbleDollar articles. Every investor, I believe, should understand such concepts.
To that list of key ideas, I’d favor adding five others—all underappreciated, I’d argue, but all central to how I think about the financial world.
1. Market portfolio. This is the worldwide universe of stocks, bonds and other investable assets, each weighted by its market value. It’s what all investors collectively own, and arguably it should be the starting point when deciding how to structure a portfolio.
My bond portfolio looks nothing like the global bond portfolio. Instead, it consists entirely of short-term U.S. government bonds, divvied up between conventional and inflation-indexed securities. This is the money I may end up spending over the next five years, so I figure I should minimize the potential damage from rising interest rates, a strengthening U.S. dollar or deteriorating credit quality.
But when it comes to stocks, I do indeed take my cues from the market portfolio. My stock investments don’t precisely resemble the global market. For instance, I’m overweighted in U.S. and international small-cap and value stocks, and also overweighted in emerging markets.
Still, the global market portfolio is my benchmark. In fact, a total world stock index fund is my largest single holding, and I always know precisely how I’m straying from the market portfolio. One way I don’t stray: My mix of U.S. and international stocks pretty much matches the global market, with roughly 50% allocated to each.
2. Intrinsic value. I can’t tell you with any certainty what the intrinsic value is for any individual stock or for the broad stock market, nor whether that value is above or below current share prices. Nobody can. But every stock does indeed have an intrinsic value—and that value changes far more slowly than each company’s stock price.
This is what gives me the confidence, whenever the broad market falls out of bed, to invest more in my stock index funds, which I did with gusto in 2008-09 and early 2020, and I’ve been doing with somewhat less gusto this year. On such occasions, I can’t be sure I’m getting a bargain. But I know the underlying businesses probably aren’t losing value as quickly as their share prices, so there’s a good chance that some panic selling is taking place—and thus I’ll potentially profit from the irrationality of others.
3. Consequences. Risk is perhaps the most important financial idea, and yet it’s one that’s often ignored. Two concepts, in particular, are worth keeping in mind. First, more things can happen than will happen. Second, we should consider not just the odds of a bad outcome, but also the consequences.
In other words, we should be aware that the future could head off in all kinds of possible directions and we need to make sure our financial life won’t be too badly damaged, no matter what comes to pass. This means taking precautionary steps that, in retrospect, will likely appear unnecessary. We’re talking about things like diversifying broadly, buying insurance and holding a stash of emergency cash. Most of the time, such steps will slow our nest egg’s growth, and yet failing to follow such steps would be the height of financial foolishness.
4. Don’t be your results. I first read about this notion in an article by Don Southworth. Don was writing about his career in sales, and how he was advised not to let his recent sales record affect his mood.
The same notion can also be applied to money management. We shouldn’t let our state of mind be influenced by our portfolio’s short-term performance or the size of our net worth, and not just because this could lead to unhappiness. If we become our results, there’s a risk we’ll make bad financial decisions.
How can we counteract this? Try to keep three notions in mind. First, if we consistently do the right things—save diligently, minimize taxes, hold down investment costs, index, diversify globally—we should eventually get rewarded, even if our prudence doesn’t show up in our results right away. Second, just because something can be measured—such as our year-to-date investment performance or the size of our net worth relative to that of others—doesn’t mean we should focus on it. Third, if we pay too much attention to our financial results, we can become obsessed with accumulating ever more, rather than figuring out what constitutes enough.
5. Money and meaning. There’s what we think we want from our money—and then there’s what we truly want. It can take a lifetime to figure out the difference.
For all of us, money brings with it a raft of emotions—what we were told by our parents and corporate marketers, what we imagine others think, and what we learned from financial experiences, both good and bad. These influences and experiences both mold our personality and are also filtered through it. For instance, you might easily shrug off a big stock market decline, but that same decline could traumatize your friends, leaving them even more risk averse. Similarly, a spanking new BMW, which you view as the height of financial foolishness, might strike your neighbors as the sure road to happiness.
Somehow, we need to peel back these layers, figuring out how we can best use the dollars we have to make our life richer. How do we know we’re being successful? The goal is to get happiness from our money that far surpasses the nominal dollars involved. If the BMW brings you joy day in and day out for years on end, it’s money well-spent. But if you sit in your cubicle, wishing you’d instead put the dollars in your 401(k) so you can quit the workforce a few years earlier, you likely bought yourself a lemon.